An idea that is gaining significant attention is that audits of corporate financial statements must be completed and paid for by an outside third-party entity
TO THE POINT
Proposed financial statement insurance could
protect shareholders and restore investor confidence
By Michael J. Moody, MBA, ARM
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An idea that is gaining significant attention is that audits of corporate financial statements must be completed and paid for by an outside third-party entity |
Enron, Global Crossing, Tyco, WorldCom, and K-Mart have become all too familiar to the investing public. Over the past several years, these firms and others like them have managed to undermine investors’ confidence in Wall Street. Failures of these firms have shaken the very foundation of trust that must exist between corporations and their shareholders. As a result, these events have led to myriad changes in how corporations transact business and have required them to establish new guidelines for corporate governance and transparency.
But that is just the tip of the iceberg. Not only is it a failure of the corporations involved, but typically it is also a failure of the corporation’s external auditor, as well. The auditors, who are, in theory, answerable to the shareholders, have failed to properly monitor the financial condition of their client companies. These audit failures have been costly to the accounting industry as a whole. Once highly rated audit firms such as Arthur Andersen are now out of business, while other well-known firms are continuing to fight shareholder lawsuits and incur costly settlements.
Background
The public auditor is a shareholder’s first line of defense to protect the shareholder’s interest from corporate wrongdoing and financial mismanagement. Historically, however, this has been a false perception of protection. One of the major corporate rating agencies, Weiss Ratings, Inc., has completed an exam of just how false this protection has been. A key finding of the Weiss study is that auditing firms almost universally failed to warn stockholders of accounting irregularities. In fact, audit firms gave a clean bill of health to 94% of public companies that were subsequently involved with accounting problems. These accounting problems ultimately cost the shareholders involved $1.276 trillion in market losses.
But certainly the audit firms did better when it came to warning of the more serious situation such as impending bankruptcies. Better? Yes. Acceptable? Not really. Even here, 42% of the audit firms gave their client companies a clean bill of health before they filed for bankruptcy. During the January 1, 2001, to June 30, 2002, timeframe, this involved 228 public companies and resulted in a loss of $225 billion in market value to shareholders.
The results of the Weiss study highlight a well-documented problem within the audit community: that of auditor independence. Most industry experts realize that it is extremely difficult for an auditor to walk the fine line between being paid by the public company client, and watching out for the shareholders’ best interest. The conflict of interest that this business practice creates is undeniable; and it has been at the center of the erosion of public confidence that has occurred over the past four years.
Help is on the way
It became clear to all the affected parties of the recent financial failures that the American public had become more and more disenfranchised and they were leaving the stock market in droves. If the company failures themselves were not bad enough, the retreat from Wall Street by many small investors certainly didn’t help the U.S. economy. By early 2002, both the administration and Congress were painfully aware of the scope of distrust among the investing public. Congress vowed to take swift and decisive action to rectify the situation and passed the massive Sarbanes-Oxley Act of 2002 (SOX). While the new SOX legislation had many unique aspects, the majority of them were directly related to assuring the public that corporations would pay a hefty price for “cooking the books” in the future. In addition, the SEC and the major stock exchanges also passed measures to help establish transparency and restore investor confidence.
While some experts are applauding the efforts that have taken place over the past few years, many investors are taking a wait-and-see attitude. Advances in the stock market have helped a few individual investors and some 401(k)s to regain some lost value, but most are still well below their previous highs. In addition, many investors have chosen to stay on the sidelines, perfectly willing to take their CD rates and consider themselves lucky. This is particular troubling since interest on CD and other savings vehicles are at an all-time low.
Problems remain
Among other things, the SEC adopted aggressive auditor independence rules, designed to minimize the possibility of conflict of interest issues. Additionally, there are specific requirements within the SOX legislation that dealt with auditor independence. All of these efforts are directed at reducing the pressure that auditors may feel to compromise their audits in order to retain the corporation’s non-audit work. In addition, many audit firms have divested themselves of non-audit consulting type activities in an attempt to neutralize the problem. This is all well and good. However, one fact remains: Auditors are still retained by the companies they audit.
Despite all of the new rules and regulations, problems remain. For example, a number of issues are currently arising regarding audit firms that aggressively market tax shelters. Many consumer groups and accounting industry representatives are already sounding the alarm and expressing concern about whether auditors selling tax shelters impair their independence. The misalignment of incentives and conflict of interest that such practices create will leave investors continuing to question the validity of corporate financial statements prepared by these auditors.
Time for a new approach
At the end of the day, most industry experts know that there can be only one permanent resolution to the auditor independence issue. In order to provide investors with the assurances they need to gain confidence in corporate financial statements, audits must be removed from the purview of the corporation. An idea that is gaining significant attention is that audits of corporate financial statements must be completed and paid for by an outside third-party entity. One potential source of outside third-party involvement may be an insurance company that could provide management oversight to the entire audit process. In addition, the insurance company could also offer an insurance product that would protect shareholders in the event that they suffered a loss as a result of misrepresentation in the financial statements.
This innovative insurance company/auditor concept is called “financial statement insurance” (FSI) and it is the brainchild of New York University accounting professor Dr. Joshua Ronen. The coverage would be offered by a professional liability underwriter and would dramatically alter the way U.S. corporations complete their financial statements. Under Dr. Ronen’s approach, an applicant for coverage would request a quotation for FSI coverage. After making application for coverage, the carrier would provide an initial quote and then complete a comprehensive risk assessment. Based on the assessment, the carrier would determine how much coverage to offer (i.e., the policy limits) and the corresponding premium.
A unique feature of the FSI coverage is that the corporation would make the information regarding the limits and premium known to investors and other interested parties. Public disclosure of the limits and premium would be made available to shareholders via the proxy statement. In addition to public notification, the corporation would request its shareholders to vote on the purchase of the coverage. It is anticipated that shareholders would be given several options on which to vote, such as the following:
• Maximum amount of insurance offered in the proposal
• A lesser amount recommended by management or
• No insurance
Since the auditors that are retained by the insurance carriers would now complete the audit, the conduct of the audit would be geared more towards assuring the absence of material loss causing misrepresentations. By necessity, the audit would provide more meaningful verification of assets and revenues. As a result, the auditor would be predisposed to insist on a greater degree of verifiability before acquiescing to management’s valuations.
Benefits from FSI
Movement to the FSI approach would result in a number of benefits for most of the participants in the audit process. First and foremost, FSI will finally remove the conflict of interest issue from the external audit process. This would result in a realignment of incentives so that external auditors could provide an objective view of a corporation’s financial health as measured by their financial statements. Shareholders would have yet another level of assurance that the financial statements that they depend upon are being prepared at an arm’s length. Publication of both the available limits and premium would also provide a clear signal to the investing public of the quality of each corporation’s financial statement and assist investors in making the most appropriate purchases.
Underwriters for their part should be interested in the basic changes that FSI would require. The active involvement in the risk assessment and financial statement audit process would be unlike any other line of coverage that they write. Directors and officers liability underwriters, for example, are fortunate if they can obtain a current copy of an audited financials prior to determining acceptance and premium for a risk. Additionally, since the carrier would be the one establishing the relationship with the auditor, the carrier would be providing significantly more value-added services than with traditional insurance products.
Auditors too should benefit from the changes brought about by the FSI concept. For the most part, the scope and amount of audit work is expected to remain about the same, so the auditors would not have to sacrifice any of their current workload. They will, however, have to get used to working for a new boss, (i.e., the insurance company). But by establishing the relationship with the insurance carrier, they can remove the conflict of interest concerns that have followed them for years. They can go back to the original concept of guardian of the public good.
Public corporations should also see benefits from the movement to the FSI approach. In this new era of transparency, corporations will need to do all they can to instill confidence in their shareholders. Early adopters of FSI can expect to gain a competitive advantage over others in their industry segments. In addition, rating agencies and stockbrokers should be better able to assess the true value of an FSI organization, and thereby place a premium on their stock. Additionally, these companies should be the beneficiaries of a flight to quality that will be a natural outgrowth of this movement.
Conclusion
Recent actions by Congress (i.e., SOX legislation), the SEC, and the various stock exchanges are all positive developments for the investing public. But despite these efforts, one fact remains: Auditors continue to work for and be paid by their corporate clients. This relationship will continue to be riddled with potential conflict of interest situations. And rather than trying to resolve them on a case-by-case basis, a change in the relationship is required.
There is little doubt that movement to the FSI approach will result in better quality audits, more truthful and transparent financial statements and, ultimately, fewer shareholder losses. Adoption of the FSI approach should finally help to restore investor confidence in Wall Street. That is what’s commonly referred to as a win-win situation and one that should be actively promoted. *
For more information:
Web site: www.FinancialStatementInsurance.com
The author
Michael J. Moody, MBA, ARM, is the managing director of Strategic Risk Financing, Inc. (SuRF). SuRF is an independent consulting firm that has been established to advance the practice of enterprise risk management. The primary goal of SuRF is to actively promote the concept of enterprise risk management by providing current, objective information about the concept, the structures being used, and the players involved.